CHAPTER 14: CAPITAL STRUCTURE AND LEVERAGE Fixed Financing Charges = Int Exp + Pref Div

Capital Structure 3. Combined Operating and Financial Leverage or

Total Leverage – measure of total risk, how EPS is
definition: mix of investor-supplied capital that the firm uses
affected by a change in sales.
to finance firm’s assets.

-includes long-term debts, short-term debts, preference

share capital, and ordinary share capital

objective of capital structure decision = Optimal Capital Sample Problem:

Structure (financing mix that maximizes the firm’s value,
maximize intrinsic value, minimize WACC)
-changes over time due to deliberate management actions
and market actions
Risk Influencing Capital Structure:
1. Business Risk – inherent in the firm, even without
debt financing.
Measurement: Standard Deviation of the firm’s
return on invested capital (ROIC)
Factors affecting Business Risk:
a. Competition – more competitor, greater
business risk
b. Demand Variability – stable demand, lower
business risk
c. Sales price variability – unstable, greater
business risk
d. Input cost variability – uncertain, greater
business risk
e. Product obsolescence – easy to obsolete
product, greater business risk
f. Foreign risk exposure – higher earnings due
sales overseas, greater business risk
g. Regulatory risk and legal exposure – example:
legal violation = penalties
h. Degree of Operating Leverage – fixed cost is
greater than the total cost, higher degree of
leverage
2. Financial Risk – additional risk due to debt financing
(use of financial leverage)
Key attributes:
-the added risk of insolvency assumed by the
common stockholder when the firm chooses to use
financial leverage
-increase variability in the stream of earnings
available to the firm’s common stockholders.
Leverage
definition: portion of the fixed cost which represents a risk to
the firm
comprising of:
ABC company sells 50,000 units of a product at 10 pesos
each. The unit variable cost is 8 pesos while the fixed
operating cost amounted to 50,000 pesos the company
has current interest charges of 6000 pesos and pretax
preferred dividends of 4000 pesos. The corporate tax
rate is 40%.
Determine the following letter:
A. degree of operating leverage letter = 100k/50k = 2x
B. degree of financing leverage letter = 50k/40k = 1.25x
C. degree of total leverage 100/40 = 2.5x or (2)(1.25) = 2.5x
CM – FC = EBIT – FFC 100k – 50k = 50k – 10k = 40k
Effect of Financial Leverage (table - page 487)
a. Zero-debt – ROIC = ROE
b. 50% debt – higher earnings per share or expected
Rate of return, but greater risk
Determining the Optimal Capital Structure
Stock Price and Expected Earnings are positively related but,
Stock Price and Risk are negatively related. Therefore, there is
a need to balance the effect. However, it is difficult to
estimate how capital structure affects the stock price. Hence,
use the following instead:
1. WACC – capital structure that maximizes the stock
price also minimizes the WACC – easier to predict
2. Hamada Equation – beta increases with financial
leverage – formulated by Robert Hamada. – concept:
increase in debt ratio, increase in cost of debt,
increase risk, thus increase in cost of equity.
-Assumptions:
Beta is 0. Level of debt is constant. Interest tax
Shields are discounted at the before-tax cost of debt.
Debt and Equity are at Market Values.

1. Operating Leverage – extent to which fixed costs are Effect of different debt/capital ratios (table – page
used in a firm’s operation (ex: depreciation expense) 491)
& higher degree of operating leverage, greater
business risk note: increase in debt percentage, increase in
interest rate
EBIT = Sales – Variable Cost = Contrib Margin – Fixed Cost

2. Financial Leverage – extent to which fixed – income

securities (Debt and PS) are used in a firm’s capital
structures, measure of financial risks (ex: financing
charges like interest expense, preferred dividend,
and risk of being unable to cover financial
obligations) & the higher the financial leverage, the
higher the financial risk and the higher the cost of
capital
Capital Structure Theory
1. Traditional Approach
– firm can lower its WACC and increase its market
value by the use of financial leverage - Trade-off
between cheaper debt and higher priced equity that
leads to an optimal capital structure.
2. Modigliani and Miller – proved, under a restrictive
set of assumption, that a firm’s value is unaffected
by its capital structure.
Assumptions: No brokerage costs, no taxes, no
bankruptcy costs, investor can borrow at the same
rate as corporations, investors have same
information as management, EBIT not affected by
the use of debt.
Effect of taxes: deductibility of interest – favors the
use of debt financing
Effect of Potential Bankruptcy: more debt – higher
chance of bankruptcy-related problems.
Bankruptcy related costs:
a. Probability of Bankruptcy (ex: employees’
resignation, suppliers won’t allow you to
borrow)
b. Actual Bankruptcy costs (ex: legal expenses,
accounting expenses, liquidating assets
3. Trade-off Theory – firms’ trade-off the tax benefits
of debt financing against problems caused by
potential bankruptcy.
4. Signaling Theory
Symmetric information (like mm assumption) –
investors and managers have the same information
Asymmetrical Information – investors and managers
don’t have the same information.
Using debt financing to constrain managers
-conflict of interest may arise
-if limited free cash flows, then managers are less likely to
make wasteful expenditures
-One way to limit excess cash flow is to have more debt.
Hence, constrain managers action. But more debt increases
the rise of bankruptcy. Therefore, the firm should make
better judgement on the capital structure.
Pecking order Hypothesis
Pecking order:
1. Spontaneous credit
2. Retained Earnings
3. Other debt
4. New common stock
Why follow the pecking order?
-Floatation costs and signaling effects
Checklist for Capital Structure Decisions
-sales stability, asset structure, operating leverage, growth
rate, profitability, taxes, control, management attitudes,
lender and rating agency attitudes, market conditions, firms’
internal conditions, and financial flexibility open.
CHAGPTER 15: DISTRIBUTION TO SHAREHOLDERS:
DIVIDENDS AND SHARE REPURCHASES
Investor may prefer either of the following:
a. Dividends – less certain of receiving the capital gains
(Myron Gordon and John Lintner_ and steady stream
of income
b. Capital gains – more interested in saving money for
long-term or due to taxes
Target Payout Ratio - The target percentage of net income
paid out as cash dividends.
Constant Growth Stock Model:
Dividend Policy – involves the decision to pay out earnings or
to retain them for reinvestment in the firm.
Optimal Dividend Policy - The dividend policy strikes a
balance between current dividends and future growth and
maximizes the firm’s stock price.
Major Theories:
1. Dividend Policy Irrelevance Theory
- by Prof. Merton Miller and Franco Modigliani (MM)
- The theory that a firm’s dividend policy has no
effect on either its value or its cost of capital
-the only important determinants of company’s
market value are the expected level and risk of its
cash flow, value depends only on net income
-assumptions: very strict (Ex: no taxes, perfect
market)
2. Dividend Policy Relevance Theory
-affects company’s market value. Thus, dividend
policy is relevant
2.1. Bird-in-the-Hand Fallacy - MM’s name for the
Gordon–Lintner theory that a firm’s value will be
maximized by setting a high dividend payout ratio.
Therefore, higher value on dividends.
2.2. Information content effect – The theory that
investors regard dividend changes as signals of
management’s earnings forecasts. The reaction
of market due to dividend action of the company
which affects stock price.
2.3. Clientele Effect - The tendency of a firm to
attract a set of investors who like its dividend policy.
Clienteles - Different groups of stockholders
who prefer different dividend payout
policies
2.4. Catering Theory - A theory that suggests
investors’ preferences for dividends vary over
time and that corporations adapt their dividend
policies to cater to the current desires of
investors.
3. Residual Theory of Dividends Policy
- aka Residual Dividend Model
- A model in which the dividend paid is set equal to
net income minus the amount of retained earnings
necessary to finance the firm’s optimal capital
budget.
- Dividend policy: influenced by investment
opportunities and availability of funds to finance
new investments.
 -assumption: investors are indifferent between
dividends and capital gains
-Steps to follow when deciding on its payout ratio:
1. Optimal capital budget
2. Amount of equity needed to finance that budget
3. Uses retained earnings to meet equity req.
4. It pays dividends only if more earnings are
available
Factors Influencing Dividend Policy
1. Restrictions on dividend payment
1.1 Contractual Constraints – existence of debt
1.2 Legal Constraint – dividend should not be
more than the RE
1.3 Internal Constraints – available cash
1.4 Penalty on improperly accumulated
earnings - (already removed in update tax
code), refers to additional taxes if the RE is
too much.
1.5 Preferred Stock restriction - preferred
before ordinary dividends
2. Investment Opportunities
2.1 Number of profitable investment
opportunities – matured companies =
higher dividend payout ration
2.2 Possibility of accelerating or delaying
project – ability of the firm to delay projects
to have stable dividend policy.
3. Alternative Sources of Capital
3.1 Dividend Policy – small companies have
limited access to capital market, therefore
rely on internal funds causing them to
distribute less dividends. Medium to large
firms can have high dividend payout ratio.
3.2 Cost of selling new stock – high flotation
cost, less dividend payout ratio.
3.3 Ability to substitute debt for equity – if the
firm can adjust the debt ratio that will not
affect the cost of capital, then it is possible
to pay dividend.
3.4 control – if they want to issue new stocks
4. Effects of dividend policy on the cost of
retained earnings
4.1 desire for current versus future income
4.2 the perceived riskiness of dividends versus
capital gains
4.3 tax advantage of capital gains
4.4 information (signaling) content
dividends
Types of Dividend Policies
1. Stable Dividend Policy
-stable peso amount of dividends per share
2. Constant Dividend Payout Ratio Policy
-a firm pays out a constant percentage of earnings as
dividends
3. Regular Dividends Plus Extras Policy
-“low-regular-dividend-plus-extras dividend policy’
-firm maintains a low regular dividend plus an extra
dividend, if warranted by the firm’s earnings
performance.
CHAPTER 18: DERIVATIVES AND RISK MANAGEMENT
Motivation:
 Why might stockholders be indifferent to whether a
firm reduces the volatility of its cash flows
-diversified shareholders may already be hedged against
various types of risk
-reducing volatility increases firm value only if it leads to
higher expected cash flows and/or a reduced WACC
 Reason why corporations engage in risk
management
-reducing volatility reduces bankruptcy risk, which enables
the firm to increase its debt capacity
-reducing the needs for external equity , firms can maintain
their optimal capital budget
-reduced volatility helps avoid financial distress costs
-managers have a comparative advantage in hedging certain
types of risks
-reduced volatility reduces the costs of borrowing
-reduced volatility reduced the higher taxes that result from
the fluctuating earnings
-certain compensation schemes reward managers for
achieving stable earnings
Derivatives - Securities whose values are determined by the
market prices or interest rates of other assets.
1. OPTION - A contract that gives its holder the right to
buy (or sell) an asset at a predetermined price within
a specified period of time
Call Option - An option to buy, or “call,”
a share of stock at a certain price within a specified
period.
Put Option - An option to sell a share of stock at a
certain price within a specified period.
Strike (Exercise, Price) - The price that must be paid
for a share of common stock when an option is
exercised.
Option Price – option contract’s market price.
Expiration Date - the date the option expires
of
Exercise Value – value of an option if it were
exercised today (current stock price – strike price)
Covered Option – an option written against stock
held in an investor’s portfolio
Naked (uncovered) option – an option written
without the stock to bask it up.
In-the-option Call – a call option whose exercise
price < current stock price
Out-of-the-Money Call – a call option whose
exercise price > current stock price
Long-term Equity Anticipation Securities (LEAPS) –
similar to normal options, but they are longer-term
options with maturities of up to 2 ½ years.
Option Premium – Call option Price – Exercise Value
Illustration:

Inc in Strike Price = Dec in Option Premium
Black-Scholes Option Pricing Model
-Derived from the concept of a riskless hedge, this model
calculates the value of an option as the difference between
the expected PV of the terminal stock price and the PV of the
exercise price
assumptions:
-the stock underlying the call option pays no dividends during
the call option’s life.
-there are no transactions costs for the sale/purchase of
either the stock or option
-unlimited borrowing and lending at the short-term, risk-free
rate (Rrf), which is known and constant.
-no penalty for short selling and sellers receives immediately
full cash proceeds at today’s price
-option can only be exercise on its expiration date
-security trading takes place in continuous time, and stock
prices move randomly in continuous time.
2. FORWARD CONTRACT - A contract under which one
party agrees to buy a commodity at a specific price
on a specific future date and the other party agrees
to make the sale. Physical delivery occurs.
3. FUTURE CONTRACT - Standardized contracts that
are traded on exchanges and are “marked to
market” daily, but where physical delivery of the
underlying asset is never taken.
-similar to forwards, but 3 differences are:
a. future contract is marked to market on a daily
basis (gains and losses are noted)
b. no physical delivery of underlying asset
c. standardized instruments that are traded on
exchanges.
Classes:
a. Commodity Futures - A contract that is used to
hedge against price changes for input materials
(ex: Oil, livestock, fibers, woods, metals, etc)
b. Financial Futures - A contract that is used to
hedge against fluctuating interest rates, stock
prices, and exchange rates (ex: treasury bills,
bonds, certificates, deposits, foreign currency,
etc.)
Risk Management - Involves the management of
unpredictable events that have adverse consequences for a
firm
Types of Risk:
1. Speculative Risks – offer the chance of a gain as well
as a loss (ex: inv. in new projects or marketable
securities)
2. Pure Risks – offer only the prospect of a loss (ex: fire,
product liability lawsuit)
3. Demand Risk – associated with the demand for a
firm’s products or services
4. Input risks – associated with a firm’s input costs (ex:
labor, material)
5. Financial Risks – result from financial transactions
(ex: issuance of bonds, changes in interest rate or
exchange rate)
6. Property Risk – associate with loss of firm’s
productive assets
7. Personnel Risk – result from human actions (ex:
employee fraud, embezzlement)
8. Environmental Risk – risk associated with polluting
the environment (for publicity)
9. Liability Risk – connected with product, service, or
employee liability (ex: health care providers, driving
vehicle recklessly, improper actions of employee)
10. Insurable Risk – risk that typically can be covered by
insurance (ex: property, personnel, environmental,
liability risk)
Steps of Corporate Risk Management:
1. Identify the risks faced by the firm
2. Measure the potential impact of the identified risks
3. Decide how each relevant risk should be handled.
CHAPTER 16: WORKING CAPITAL MANAGEMENT –
Working capital. Current assets are often called working
capital because these assets “turn over”
Net working capital is defined as current assets minus
current liabilities.
Net operating working capital (NOWC) represents the
working capital that is used for operating purposes
Working Capital Management – involves managing the firm’s
current assets and liabilities to achieve a balance between
profitability and risk that contributes positively to the firm’s
value.
Tracing cash and net working capital
1. Operating Cycle – length of time in which the firm
purchases/produces inventory, sell it, and receive
cash
2. Cash Conversion Cycle (CCC) - The length of time
funds are tied up in working capital, or the length of
time between paying for working capital and
collecting cash from the sale of the working capital.
2.1 Inventory Conversion Period - The average time
required to convert raw materials into finished
goods and then to sell them
2.2 Average Collection Period (ACP) - The average
length of time required to convert the firm’s
 receivables into cash, that is, to collect cash -Greater flexibility for ST debt
following a sale. -ST debt has lower cost
2.3 Average Payment Period - The average length -ST debt is riskier
of time between the purchase of materials and 1. Interest Expense can fluctuate widely
labor on credit and the payment of cash for 2. Temporary recession may have adverse effect
them
Preference of managers

Aggressive managers  more ST financing

Conservative managers  more LT financing

B. CASH MANAGEMENT

Basic obj: to keep investment in cash as low as possible while

still keeping the firm operating efficiently and effectively

Strategies in monitoring cash balances

-Accelerate cash inflows

-Monitor cash disbursements

-Minimize idle cash

-Avoid misappropriation and losses

Reason for holding cash balances:

-Transaction Motive

-Precautionary Motive

-Speculative Motive

-Contractual Motive

Determining the target cash balance

-Cash budget (presents the expected cash inflows and

outflows)

-Cash break-even point (BEP) (is the sales level At which

total cash inflows is equal to total cash outflows

Formula:

Cash BEP in unit sales = Fixed Monthly Payments/Unit Contrib

A. ADDRESSING WC POLICIES Margin

Working Capital Policy Cash BEP in peso sales = Fixed Monthly payment/ Contib
Margin
1. Investment Policy (appropriate size)
-Optimal Cash Balance using the Baumol cash model

2. Financing Policy (how to finance)

 Choosing among the WC financing policies:

-Negotiation with ST debt is faster

Cash Management Techniques
a. Synchronizing Cash flows – inflows coincide with
outflows
b. Using floats
Floats – difference between the balance shown in a
firm’s books and the balance on the bank record
due to delays
Disbursement Float – Bank bal > Book Bal;
maximize
Collection Float – Bank Bal < Book Bal; minimize
Mail Float – amount of customers’ payment
that have been mailed by customers but not
yet received by the seller-company
Processing Float – amount of customers’
payment that have been received by the
seller but not yet deposited
Clearing float – amount of customers’
checks that have been deposited but have
not yet cleared yet.
c. Accelerating cash collections
-Prompt biling and periodic statements
-incentives such as trade and cash discounts
-prompt deposit
-lockbox system
-direct deposit to firm’s bank account
-electronic depository transfer or payment by wire
-maintenance of regional collection office
d. Slowing disbursements
Techniques:
-Centralized processing of payables
-Zero balance accounts – requires checks to be
writte from special disbursements accounts having
zero-peso balance with no minimum maintaining
balance required. Funds are automatically
transferred from a master account when a check
drawn from ZBA is presented/
-Delaying Payment
-“Pay the float”
-Less frequent payroll
e. Reducing the need for precautionary balance
-More accurate cash budgeting
-lines of credit (pre-arranged loans)
-temporary investments
C. MARKETABLE SECURITIES MANAGEMENT
Basic obj: convert cash into interest-bearing marketable
securities
Reason for holding marketable securities:
-Substitute for cash
-held as temporary investment
Factors influencing the choice of marketable securities:
-Risk
a. Default risk – refers to the chances that the issuer
may not be able to pay the interest or principal on
time or not at all.
b. Interest rate risk – refers to fluctuations in
securities’ price caused by changes in market
interest rates.
c. Inflation risk – refers to the risk that inflation will
reduce the “rela value” of the investment
-Marketability – referes to how quickly a security can be sold
before maturity without a significant price concession
-Maturity – mmaturity date of marketable securities held
should coincide, when possible, with the date at which the
firm needs cash, or when the firm will no longer have cash to
invest.
D. ACCOUNTS RECEIVABLE MANAGEMENT
Basic obj: to have both the optimal amount of receivables
outstanding and the optimal amount of bad debts. This
balance requires the trade-off between the benefits of more
credit sales, and the costs of accounts receivable such as
collection, interest, and bad debts cost.
Credit Policy
-Guideliness for extending credit to customers
-components:
Credit standard – the criteria that determine which
customers will be granted establishing credit
standards: (5 C’s)
a. Character – customers’ willingness to pay
b. Capacity – customers’ ability to generate cash
flows
c. Capital – customers’ financial sources
d. Conditions – current economic or business
conditions
e. Collateral – customers’ assets pledged to secure
debt.
Credit terms – credit period and discount offered for
customers’ prompt payment.
Collection Policy – procedures the firm follows to
collect accounts including past accounts
 basic objective: to maintain at a level that best balances the
estimates of actual savings, the cost of carrying additional
inventory, and the efficiency of inventory control

techniques:

a. Inventory Planning –

b. Inventory Control

b.1 Fixed Order quantity system – an order for a fixed

quantity is placed when the inventory level reaches the
reorder point
E. INVENTORY MANAGEMENT
b.2 Fixed Reorder cycle system – aka periodic review or
replacement system, orders are made after a review of
inventory levels has beem done at regular intervals
b.3 ABC Classification System – inventories are classified for
selective control

A items – high value

B items – medium cost items

C items – low cost

b.4 Materials Requirements Planning (MRP) – designed to

plan and control raw materials used in production. The
demand for materials, which is assumed to be dependent on
some factors, is programmed into a computer.

b.5 Enterprise Resource Planning (ERP) – integrates the

information systems of the whole enterprise. All
organizational operations are connected and the organization
itself is connected with its customers and suppliers

F. SHORT-TERM SOURCES FOR FINANCING CURRENT

ASSETS

Factors considered in selecting sources of short-term funds:

-Cost

-Availability

-Influence

-Requirement